Kratos Defense & Security Solutions, Inc. (KTOS) Q3 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Kratos Defense & Security Solutions Third Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference may be recorded. I would know like to turn the conference over to your host Ms. Deborah Butera, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary. Ma'am, you may begin.

Thank you, Valerie. Good afternoon, everyone, and thank you for joining us for the Kratos Defense & Security Solutions Third Quarter Conference Call. With me today is Eric DeMarco, Kratos' President and Chief Executive Officer; and Deanna Lund, Kratos' Executive Vice President and Chief Financial Officer. Before we begin the substance of today's call, I'd like to make some brief introductory comments. Earlier this afternoon, we issued a press release, which outlines the topics we plan to discuss today. If anyone has not yet seen a copy of this press release, it is available on the Kratos corporate website at www.kratosdefense.com. It is also available on the SEC's website. Additionally, I'd like to remind our listeners that this conference call is open to the media, and we are providing a simultaneous webcast of this call for the public. A replay of our discussion will be available on the company's website later today. During this call, we will discuss some factors and matters that are likely to influence our business going forward. Any matters discussed today that are not historical facts, particularly comments regarding our future plans, objectives and expected future performance, and the potential impact of sequestration, federal government shutdowns and the constraints on the federal budget constitute forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including those found in the risk factors section of our annual report on Form 10-K and our quarterly reports on Form 10-Q, which could cause actual results to differ materially from those suggested by our forward-looking statements. We encourage all of our listeners to review our SEC filings, including our annual report on Form 10-K and any of our other SEC filings for a more complete description of these risks. All forward-looking statements are qualified in their entirety by this cautionary statement, and we undertake no obligation to revise or update these forward-looking statements to reflect events or circumstances after today's date. This conference call will also include a discussion of non-GAAP financial measures, as that term is defined in Regulation G. Certain of the information discussed for the quarter ended September 28, 2014, including adjusted EBITDA and the associated margin rates; pro forma EPS from continuing operations, excluding restructuring and acquisition-related items and other; amortization of purchased intangibles; stock compensation expense; cost relating to pending contract change orders and contract modification adjustments; noncash impairment charges and cost on completed contracts using a cash tax rate and using a statutory tax rate of 40%, are considered non-GAAP financial measures. Kratos believes this information is useful to investors, because it provides a basis for measuring the company's available capital resources, the actual and forecasted operating performance of the company's business and the company's cash flow, excluding extraordinary items and noncash items that would normally be included in the most directly comparable measures calculated and presented in accordance with Generally Accepted Accounting Principles. The company's management uses these non-GAAP financial measures, along with the most directly comparable GAAP financial measures, in evaluating the company's actual and forecasted performance, capital resources and cash flow. Non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information presented in compliance with GAAP and non-GAAP financial measures as reported by the company may not be comparable to similarly titled amounts reported by other companies. As appropriate, the most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to the company's financial results prepared in accordance with GAAP are included in the earnings release, which is posted on the company's website. In today's call, Mr. DeMarco will discuss our financial and operational results for the third quarter of 2014. He will then turn the call over to Ms. Lund, to discuss the specifics related to our financial results. Mr. DeMarco will then make some concluding remarks about the business, and then we will open the call up to your questions. With that said, it is my pleasure to turn the call over to Mr. DeMarco.

Thank you, Deborah. Q3 was challenging for Kratos, and in particular KPSS, as we experienced a number of contract award delays, delays in expected starts for work already under contract and with existing customers, a number of Kratos' awards are being protested by competitors and other factors. However, in spite of these challenges, Kratos received a significant number of new contract awards in the third quarter. Our book-to-bill ratio was 1.2:1, including an $81 million award we announced today. We grew our backlog and our qualified bid pipeline increased 15% to approximately $7 billion, reflecting the increased number of opportunities we are pursuing. In Q3, KGS, which represents approximately 81% of our business, grew both revenue and EBITDA sequentially over Q2 and year-over-year, though not at the rate we had previously expected. Our KGS business has grown sequentially quarter-over-quarter throughout 2014, and we expect continued sequential growth once again for Q4 over Q3. In KPSS, our critical infrastructure security business, in July, we received a notification of the largest contract award in its history at $81 million. We should begin ramping in 2015, and we have just recently been informed that we have been selected for a new $9.5 million award and a $4 million award from 2 large mass transit authorities, and we expect to have formal contract documents completed by the end of the fourth quarter. Since the end of Q2, our critical infrastructure security business' backlog has increased, and we are currently pursuing several additional large new security system deployment opportunities in the business development pipeline. Overall, we expect -- we continue to expect Kratos' fiscal 2014 fourth quarter to be the strongest of the year, for both revenue and adjusted EBITDA, and for Kratos' second half financial performance to be higher than the first half of 2014, though not to the extent that we had previously expected. In the third quarter, we continue to make progress on our strategic plan and roadmap, including in our core unmanned systems, electronic products and satellite communications business areas. Programs we are on currently or plan on supporting include CPAS [ph], SBIRS, WGS, Aegis, Patriot, SABR, F-35, SEWIP, APR 39, NGJ, AMDR and 3 dealer. And since Q2, we have continued to make progress in either increasing or achieving Kratos' design to enter product content positions on certain of these electronic warfare, missile radar, ISR and aircraft platforms. Since the second quarter, we have had a number of successful flights for our high-performance Unmanned Aerial Drone Target Systems, including our most successful and important test flight to date, with one of our most important customers, with our newest aircraft, for one of our companies largest programs. In Q3, we completed negotiations with a U.S. government customer on an unmanned target drone system contract valued at approximately $75 million for approximately 75 aircraft, which we expect to receive formal award by the end of this year and begin production in 2015. In the third quarter, we negotiated and have now executive a contract for the production and delivery for 20 of our newest high-performance unmanned target drone systems, with a separate U.S. government customer, which we will perform on throughout 2015. In Q3, we completed negotiations on an approximate $30 million order, with a separate international customer, which we had expected to be under contract in Q4 of this year, but the formal award has now been pushed out to the first half of '15. In the third quarter, we received a $4.8 million unmanned aerial drone command and control system and services delivery order from a U.S. government customer, and we have also recently responded to an existing international customer's request for pricing, for approximately 125 of our unmanned aerial target drone systems. In Q3, we continued production of 3 of our new UCAS platforms. We are scheduled to participate in a certain customer's war game and simulation in Q4 of this year, and we are planning on test flights with this aircraft in late 2015. In the third quarter, Kratos' Unmanned Systems division bid and proposal pipeline increased approximately 60% from $682 million at the end of Q2 up to $1.1 billion at the end of Q3, as we have now completed development on certain of our new high-performance unmanned aerial platforms, enabling us to pursue expanded customer and market opportunities, and we have enhanced our business development and resources and efforts. In summary, though our third quarter and expected Q4 were impacted by a number of competitive protests, contract delays and work delays, we won a large number of new contract awards. Our book-to-bill ratio was the best so far this year, our backlog increased, our bid pipeline continued to expand, and we had a successful customer test flight on our largest program opportunity. We made progress across all strategic plan areas. As we complete 2014 and head towards 2015, the industry remains extremely challenging, and is expected to continue to be so for the foreseeable future, including a continuing resolution now being in place since October 1, no Federal or DoD 2015 budget, there's increased demands in our country's already stretched National Security-related resources, due to recent world events and potential sequestration returning again next year. In addition, as a result of these industry conditions, we expect increased competitive protests and award delays will continue for the foreseeable future. Accordingly, in the near term, we will control what we can control, including expanding our qualified bid pipeline, continuing to bid on new contract opportunities, aggressively managing our cost structure, restructuring the business, and making targeting and -- targeted investments in our long-term strategic focus and large new program opportunity areas, including unmanned systems, electronic products and satellite communications. Lastly, with the objective of enhancing shareholder value and related to the current and expected to remain challenging industry environment, we also announced today that our Board of Directors has retained an investment banking firm to assist it in formally reviewing our businesses, markets and competitive positioning and to evaluate strategic alternatives, including the potential divestment of certain of our non-core businesses. With that, I'll turn it over to Deanna.

Thank you, Eric. Good afternoon. Our third quarter revenues of $217.1 million came in below our expected range, due to a number of competitor protests of contracts we had been awarded, which either resulted in a stop work order issued by the customer, a brief procurement of the award or a stop work until the protest was dismissed. On a sequential basis, revenues increased for our KGS segment from $165.7 million to $174.3 million. The sequential increase of $8.6 million or 5.2% in our KGS segment was offset by the sequential decrease of $20.8 million or 32.7% in our PSS segment from $63.6 million to $42.8 million. While we expected a sequential quarterly decline for PSS due to the sizable delivery of communications equipment of $13 million, which occurred during the second quarter, we did not expect the decline to be as significant. The PSS Q3 revenues were impacted by the delays in expected contract awards, including delays caused by competitive protest and reprocurement of an award. As a reminder, approximately 50% of our PSS revenues are typically generated by a large volume of smaller projects of $250,000 or smaller. Consequently, a good amount of PSS' quarterly revenues is booked and delivered in a given quarter. That does present challenges in forecasting revenues, especially when the larger procurement awards are delayed, which typically provide more visibility due to the associated backlog. On a year-over-year basis, revenues decreased 4.1% or $9.3 million from $226.4 million in the third quarter of 2013, with a year-over-year decrease in our PSS business of $9 million from $51.8 million to $42.8 million and a near flat year-over-year change in our KGS business, which declined slightly at $300,000 from $174.6 million to $174.3 million. Our PSS business was impacted by the delay in awards mentioned previously. The year-over-year comparison for our KGS business was impacted by the following: our legacy services business continued to decline due to competitive pricing pressures and commoditization, which decreased $8.6 million from $22 million to $13.4 million; the legacy services business revenues are down sequentially $3.4 million from $16.8 million from the second quarter; revenues were also impacted by the expected reduction in 2 sizable satellite communications projects, as the scope of work completed its natural contract life cycle, transitioning from production to sustainment, resulting in net aggregate reduced revenues of $3.8 million; and the reduction of shipments of certain of our aerial target products of $6.5 million, which has been impacted by the delays of certain expected awards of unmanned drone systems for international customers, which Eric mentioned earlier. These year-over-year declines were offset partially by increases of work performed in our training business of $6.1 million, driven by increased work in our Aircrew Trainer business, increased shipments in our specialized modular systems business of $6.5 million, driven by growth in our surface combatant radar systems and hardened facility product lines, increased specialized work performed on government weapons ranges of $5.1 million and increased shipments of our electronic warfare products of approximately $1.5 million. As we mentioned last quarter, we have initiated an aggressive internal vendor and supplier cost reduction plan across the company, especially in our PSS business for which we expect to start seeing an impact by Q1. We had originally expected to see an impact in the fourth quarter. However, the cost negotiations with key suppliers have taken longer than originally anticipated. We continue our cost rationalizations process, which will also help to enhance operating efficiencies, while improving our operating margins. Our adjusted EBITDA of $22.5 million for the third quarter is from continuing operations and excludes the following charges, which have been reflected as adjustments, since we either believe the items are not operational and/or nonrecurring in nature. Acquisition and restructuring related items of $5.7 million, which includes employee termination and excess capacity cost of $1 million in our KGS segment, as we continue to right size the business, $2.6 million of noncash charges and costs on previously completed contracts in our PSS business, which relate to a write-down of the carrying value of the inventory and certain receivables and cost adjustments on completed contracts, and $2.1 million of cost related to pending customer change orders related to scope increases and additional work performed in our PSS business. We have submitted or are in the process of submitting change orders for 2 sizable PSS projects, one of which was recently completed, the other which is very close to being completed. We believe we will be successful in obtaining the customer change orders to reimburse us for additional work we have performed at our customer's request, based upon our historical experience. However, from a conservative accounting approach, we have recorded all the cost we have incurred on these 2 projects without reflecting any of the anticipated change orders we have submitted or are in the process of submitting, until actual receipt of the signed change order. The contract design retrofit costs and contract conversion adjustment of $3.2 million is primarily related to an adjustment related to the conversion of a cost plus type contract that was converted to a firm fixed-price contract for one of our largest customers in our Unmanned Systems business. This program includes multiple phases. The first of which is developmental and the following phases, which are for aircraft production. The conversion adjustment reflects the economic profile solely based upon the initial development phase, without consideration of the following phases. In effect, making the production phases more profitable, though not changing the total economics of the entire project. The charge is net of retrofit design cost matters related to an aerial target project. As expected, our adjusted EBITDA was impacted by the continued increase IR&D investments during the third quarter, which were at $5.9 million or 2.7% of revenues. On a GAAP basis, net loss for the third quarter was $10.9 million, which included income from discontinued operations of $200,000, $5.7 million of expense related to amortization of intangible assets, $2.9 million of noncash stock compensation expense, as well as a $200,000 income tax benefit. Moving to the balance sheet and liquidity. Our cash balance was $16.2 million at September 28, plus $5.2 million in restricted cash. Cash flow from operations for the third quarter was a use of $7.9 million resulting primarily from a use in net working capital requirements of approximately $11 million. The primary use related to production of certain combatant and hardened facility lines, with sizable milestone billings are expected to be collected in the fourth quarter and is expected to generate cash flow of approximately $8 million to $12 million at that time. Investments in our Unmanned Systems business also contributed to net working capital used during the quarter. Our day sales outstanding increased 1 day from second quarter to 107. With the expected collection of the combatant and hardened facility lines in the quarter, DSOs are expected to decline. Our contract mix for the third quarter was 83% of revenues generated from fixed-price contracts, 12% from cost-plus contracts and 5% from time immaterial contracts. Revenues generated from contracts with the Federal Government were approximately 64%, including revenues generated from contracts with the DoD and with non-DoD Federal Government agencies. We also generated 9% of our revenues from state and local governments, 13% from commercial customers, 14% from foreign customers, with our aggregate non-DoD revenues comprising 36% of our total revenues. Backlog at quarter end was $1 billion, including the $81 million critical infrastructure security system deployment contract we announced today, for which we received award notification in July 2014. Backlog was $1.81 billion with $549 million funded, including the $81 million recent award. Backlog at the end of the second quarter was $1.46 billion. Now moving on to financial guidance. The company today updated its financial guidance of fourth quarter revenues to $225 million to $245 million, adjusted EBITDA of $20 million to $23 million and adjusted free cash flow of $5 million to $10 million, after payment of the interest payment of $22 million in November. EBITDA is expected to continue to be impacted by internally-funded investments by the company with IR&D now continue to -- expect it to continue at higher than normal levels as a percentage of revenues throughout the fourth quarter, as the company continues to pursue large new opportunities in the unmanned systems, electronic warfare, radar-signal processing and satellite communications areas. As Eric mentioned earlier, we are continuing to make investments from IR&D and CapEx perspective in certain of our electronic products, satellite telecommunications and unmanned systems businesses. Our total estimated CapEx for 2014 is $16 million to $18 million, with the most significant investment being in our Unmanned business, as we are -- as we will be in manufacturing an increased number of aircraft for expected customer presentation requirements. We are providing our adjusted EPS estimates for 2014 of $0.10 to $0.15 reflecting earnings from continuing operations, excluding amortization cost, excluding stock compensation cost, excluding the loss on extinguishment of debt, excluding contract design retrofit cost and contract conversion adjustment restructuring and acquisition related items, computed using on an annual estimated cash tax pay of approximately $2.2 million. I will now turn the call back over to Eric for closing remarks.

Thank you, Deanna. With that, we'll turn it over to the moderator for any questions.

[Operator Instructions] Our first question comes from Mike Crawford of B. Riley.

Eric, there was a number of contract protests and other delays in this period. What made this period different from the similar types of protests and delays that we've seen over the past couple of years? And then the second part of that question is to what extent is Kratos itself protesting others' awards? And what are -- what is the fate, if any, of those actions?

We had planned in our forecast for Q3 and Q4 a number of new opportunities that we were bidding on, which we won. One -- I'll name a few in detail. One was a $46 million radar contract, which I believe the run rate was -- is just under $1 million a month. And we were awarded, I believe, very early in Q3, I think before we even announced Q2. It was immediately protested and it's going to run the whole -- entire 100-day GAO period. We had planned on winning and we did win. Our critical infrastructure deployment in a very large mass transit authority on the West Coast. It was protested. The protest was thrown out. I believe it was protested again, and we still haven't received formal notification on it, and the critical infrastructure work is immediate book and burn. We had been protested on a large equipment delivery order that we just recently got cleared by the GAO. In addition to that, we have a number of awards in our pipeline that we have gone through orals. We have received very good feedback, and we believe we're going to win. They will probably be protested, because some of the guys that have protested us previously, very recently, we're competing with here. And so that's given us cause up on -- caution on when to schedule them. So we had a significant ramp in our forecast, which included a number of new contract awards. The vast majority of which we won, a significant number of them were protested. That is the difference. Now to the second part of your question. We have tried not to protest historically, unless there was valid reasons to protest. It appears though, from a competitive standpoint, as I just mentioned a minute ago, if you protest and it has any type of basis at all. If you're the incumbent, you can keep the work for the 100-day run period. And if you're the loser, you protest because there are so few new programs coming, you really have nothing to lose. We have not aggressively previously done this. However, we have made the decision in the past couple of months. We are going to be much more aggressive offensively on the protest side going forward, because that's what the competitive landscape is demanding.

Okay. And then on this AFSAT test flight that you did in, I think, September, what is the scheduled pace there, as you move from development to preproduction to potential production?

I'll comment on what's publicly available on that. And there was an article that came out recently on this. We are scheduled for a number of additional test flights throughout 2015. And if we are successful on those test flights, which I believe we will be, then we are currently under contract with production options. And we will move into low rate initial production subsequent to that, and then full rate reproduction after that.

So the low rate in 2015, but not full rate?

No. Full rate production would be out. Low rate initial production, right now, it's approximately across -- the 2 options is approximately 100 aircraft, I believe, across both of them. And that would be for a couple of years then once you qualify, you satisfy the requirements in LRIP, then you go to full rate production. That's on that one program.

Okay. And then last question relates to the hiring of a bank to pursue alternatives. If the company were to consider selling the Public Safety & Security business, what are some of the attributes of that business that would interest buyers? And what comp transactions, if any, could you point to?

Right. So what would interest buyers, hypothetically, on that, hypothetically is why we're so interested in that business, is because the demand right now for critical infrastructure solutions is extremely strong. We are seeing additional competitors come in. We are seeing that. We are seeing protests now when we win. We are seeing that. But there is a very strong demand for these types of very specialized systems on strategic assets and critical infrastructure in this country. And it is clearly a growth area. And as you know, this business has been a strong growth engine for this company the past few years. It's one of the few areas in the security space, where there are significant growth opportunities from a market standpoint. That is why it is very important to us. And in my opinion, that's why it would be very important to a potential someone else who would want it.

Our next question comes from John Nelson of State of Wisconsin Investments.

Congrats on all of the awards, and my sympathies on all of the protests and the delays. The -- you had mentioned you plan on changing your strategy on the protest side. And will that result in substantial increase in legal costs that we should project for the coming year?

That's an excellent question. The answer to that is no, sir. We have put together the plan where we are going to use our internal resources. Our Senior Vice President and General Counsel will lead that with her existing staff, and that is our plan. We will be doing this virtually all -- substantially all with internal resources.

Okay. And do you think that a couple of competitors might get the message if this goes on?

No.

Or do you think it really is just a constant struggle?

I do not believe that it is going to abate, in any way, any time in the near future, and it very well may increase, as a result of competitive pressures and there are so few new large program opportunities. And for example on the defense side, if you're bidding on a multi-year radar-directed energy program and you lose, you're out for 5 years, if it's a 5-year contract, and people are being very, very aggressive. Also, John, what a dynamic that's happened, and I know you're aware of this, is because of the change in procurement philosophy under this administration, customers really don't choose contract winners anymore. Contracting offices do, behind the customer. So when you protest, you're really not ticking off the customer anymore, because it's out of his hands, especially when there are low priced technically acceptable awards, and the contracting office opens the bids, goes to the low-price, if it's barely technically acceptable, he awards it. So the protest goes that route now and so I think people are calculating that the risk of pissing off a customer and that customer remembering that later on has really abated, because of the change in procurement philosophy.

Interesting. Okay. Do you think the change in the -- with the latest series of elections, do you think that, that will bring any significant changes to your outlook or the outlook of military spending over the next year or 2?

I am -- I, obviously, don't know, but I am worried. I'm concerned, that in the near near-term, that with the Republicans now having both the House and the Senate, that they may, for a while, just present things to the President for him to veto, to build a veto record. That's -- I don't know anything. That's just -- I'm concerned about that. So it's unclear. We're going to see a lot -- we're going to know a lot come, I think, it's in December 11 or 14 when the CRA expires. Are we going to put in place another CRA? And then will that CRA go through January? Then when the new Congress sits, then will we have a budget? So I think over the next 3 or 4 months, this is going to become a lot clearer.

Okay. All right. And then on the UCAS program. The -- has that gone according to plan, as far as your progress? And is there anything additional that you can share with us about that, since that's one of your long-term strategic initiatives? One of your big ones, big, big ones.

Yes, sir. As we -- right now, everything is on track. We are tracking to the integrated master schedule that we have for the aircraft and then the integration of the various systems into the aircraft with either our sponsors or our customers' equipment toward the demonstration flights in the latter half of the late 2015. We -- very importantly, we -- our aircraft in simulation is going to be in a very important war game next month, which is -- this is very important for us. And we have received word very recently that if that goes successfully and our demo flights goes successfully, that it's possible -- probable, that in 2016, a number of our UCAS aircraft are going to be included in actuality in another very large war game. So thus far, knock on wood, things are tracking.

Okay. I haven't asked this in a while, but who are your major competitors in the target drone area?

In -- historically, it -- historically, was Northrop Grumman. And Northrop Grumman -- we/CEI, we defeated them, and that's why we are, right now, the primary target provider of the U.S. Air Force and the U.S. Navy. On the supersonic target side, supersonic, Orbital Sciences is our competitor. And then internationally, we're the big player, but we run into EADS. I think they changed their name to Airbus now and Make it [ph].

Okay. And then just one more question. On the -- for example, on these latest big wins that you had on the KPSS side, anything besides price that really swung you to the win?

Yes. On the one we announced today? It was our technological solution that won. It was very -- we're very pleased at that. It was -- we won with our technological solution on that. And actually, the one at the -- on the West Coast, at the large MTA that's been protested a couple of times, that one, by my understanding, is that also was based on our technological solution, not on price.

Our next question comes from Sheila Kahyaoglu. One moment. I apologize, our next question comes from Mark Jordan of Noble Financial.

Eric, question relative to the service gross margin drop down 300 basis points sequentially. Is that a function of both the change order, in essence, reserve that you set up? And then also, was there some amount of inefficiency due to kind of bench time relative to the delays of the receipt of the business?

Mark, this is Deanna. Most of that decline was related to the Public safety business on those change orders, where we recorded the cost and not the estimated revenue yet, until we actually receive those change orders in hand.

Okay. So then it would be -- one should assume that the profit -- the gross profit margin of service should bounce back smartly with the absence of the change order reserves and start of some of the new business finally being received?

That's correct.

The 2 lines in the reconciliation to adjusted EBITDA with the 8.9, you implied that those were fairly transitory, so that they should be back down to a much more modest level in the fourth quarter? Is that correct?

Yes.

Okay. And then, I guess, final question I have is, you have a number of contracts for unmanned targets in the foreign military sales area. And I guess, I contrast that to the aircraft and the work you're doing trying to develop a craft that will survive in contested airspace. Should we assume that those foreign military sales or export sales would ramp much more quickly because those are finished, in essence, established technical platforms, and that she should be able to -- there wouldn't be a development cycle relative to those?

Yes, sir. Exactly. Yes, sir.

Our next question comes from Sheila Kahyaoglu.

In terms of government profitability, how should we think about the R&D profile of the business, and as you ramp up on, maybe your increased sales effort for UAS?

Sheila, this is Deanna. So on the R&D efforts, we do expect that it's -- to still be at a heightened level in the fourth quarter and to probably be at that elevated level, at least for the first half of 2015, as we continue work on a number of these areas where we have seen some designed-in wins in this area, but there are additional opportunities we are working on. So we do expect that elevated R&D level to continue, at least, through the first half of '15.

Okay. And then, I guess, sticking to the profitability profile. Within Public Safety & Security, just to make sure I understand it correctly, the conversion of the cost-plus contract was about $3.2 million, and that was all within that segment, but you also didn't recognize any revenue, whether it was $10 million to $15 million for that segment. So it's not like -- the margins do snap back quite immediately. It's not like you're going to break even in Q4. You do get -- as you get the top line, you should go back to normalized load in mid-single-digit margin level?

That's correct. And the actual -- the adjustment related to the change orders is $2.2 million.

Okay. Got it. And then, in terms of the $81 million contract you announced today -- congratulations. Just, would that make -- should we think about that when modeling it out $15 million per year. So this could be -- would this be your largest PSS customer?

Yes, and yes.

Okay. So it's quite a big -- we should assume quite a big bounce in PSS for next year, in terms of the top line.

This does start to ramp with next year. Yes, it absolutely does.

And Sheila, I think the first year ramp will probably not be as large as the year is going out, because the first year ramp will be based mostly on engineering and design-type work that we will do up front. So I think you'll see a larger ramp from '15 to '16.

Our next question comes from Eric Still [ph].

Given the misguidance and the fact we're halfway through the quarter, can you -- first off, tell me how much conviction you have in hitting that fourth quarter guidance? And then secondly, give us the big drivers on the $15 million drop in the fourth quarter guidance?

Right. So the biggest drivers in the fourth quarter were a contract that we won that was protested. And that protest will not be resolved until 2015. It's a second contract that we were awarded that was protested, that was thrown out, that was protested again and we still have not received that award. The third one was a contract that was -- we won in Q2. It was protested. This is a hardened structure type of a contract that we've just received word that our award was sustained. We won. We will not be able to execute on that now until 2015, relative to Q4. That $46 million contract that was protested, that remains in protest, that was scheduled to go through Q3 and into Q4, that is impacting us there. And on -- you asked about conviction. It is possible. We have a few other new contract opportunities. We believe we're going to win, that they could be protested. And that could move things out to the right again out of Q4. It is not of the magnitude of the opportunities that we had in Q3. So if they were to get protested and the protest were to be honored and stop-work orders are issued, it could impact us. But it is, once again, it's not of the magnitude or the number of opportunities that we had in the third quarter.

So I know you're not giving 2015 guidance, this is a several-fold question. Generally, you're looking for some top-level positive and negative impacts on sales and EBITDA. And then, to dovetail off that last question, how confident are you that you're going to resolve those protest in 2015? And should we assume that, that lost $15 million in EBITDA comes back in '15?

The contracts that have been -- that we've been awarded that have been currently protested, as I mentioned, the typical GAO period is 100 days. So they should all be resolved one way or the other early in 2015. If we are hit with additional ones between now and the end of the year, they could run into depending on when we were hit with them late Q1 or early Q2. So it's hard to say, based on that.

But either way, we'll know in 100 days?

We will -- on ones that have already been protested, we will know within 100 days or less. If we were protested -- like on this one, we were protested, like, in July, late July. We should know on that one soon enough.

Okay. Got to love the litigious society we live in. Looking at PSS, if you sell it, what are you going to use the proceeds for? I mean, I know that your covenants are pretty tight, but what could you see doing with those?

We would either net down or pay down debt. We are not acquiring anyone. There are no acquisitions at all. So it will be either a net down or a pay down of the leverage.

And no shareholder-friendly stuff?

No, no. If we're successful, over the next few years, on some of these programs, that will take care of itself.

Okay. Great. And then, I'm new to your name as you know. Looking at your book-to-bill, it moved from 1 to 1.2. I'm assuming that does not mean your revenues are going to grow 20% next year, but how should we look at your top line going into next year given -- I know we've got a Republican Congress, but I don't think that we're going to make big moves on the budget. But in a static world, the government doesn't do anything positive or negative, how should we look at that book-to-bill coming through your top line?

We are -- I always like to answer all of your questions very directly, but on this one, because of the change in Congress we just had, because we're in a CRA position, and it's unclear, I would like -- I'm going to wait until we have more clarity, like I explained a few -- a little -- a few minutes ago, before we comment on next year.

Our next question comes from Michael Ciarmoli of KeyBanc Capital.

Eric, just most of mine have been answered. Just one, for clarity purposes. You guys had a number of the unmanned award or contract opportunities that you laid out last quarter. It think they came close to $120 million. Can you give us a sense of how much of those revenues or those contracts you can expect to expect to flow through the top line next year? Just for modeling purposes, can you kind of give us a sense of where we are? How we should be thinking about that?

Yes. So on the $75 million opportunity that we have negotiated, and I believe we are going to receive that formal contract award this month, that's what we've been told by the customer, that will be approximately $25 million or $30 million next year, $25 million or $30 million the following year and then the balance, the year after that. On the $30 million international, it's just under $30 million one, if we get that one early in the year, we will substantially execute that in 2015. Substantially. If we get it in the second quarter, maybe it's 2/3 or 3/4, and then the balance in the next year. We did receive the -- from a separate U.S. government agency, an order for 20 aircraft. I would model in '15, approximately $6 million or $7 million for that in '15.

I'm showing no further questions at this time. I'd like to turn the conference back over to Mr. Eric DeMarco for any closing remarks.